Tips for Tax-Efficient Real Estate Transfers to the Next Generation

By Mike Shayestehfar, Wealth Advisor, First Republic Investment Management
January 2, 2017

High-net-worth families often hold a large share of their wealth in real estate, whether personal residences or investment properties. But leaving property outright to your heirs can be risky — they may face significant estate taxes and could be forced to liquidate properties to pay the tax bill.

The federal estate and gift tax exemption for 2017 is $5.49 million for individuals and $10.98 million for married couples, and those exemptions typically rise each year to keep pace with inflation. Any excess value of an estate above the current exemption amount is taxed at up to 40 percent.

Families who want to minimize their estate taxes — or at least ensure their heirs don’t have to sell properties to cover the tax bill — should consider the benefits of these four estate-planning tools.

Irrevocable Trusts.

The sooner real estate is transferred out of your estate, the more value that can be protected from estate taxes. Creating an irrevocable trust allows you to gift real estate to your heirs today while removing any future appreciation from your estate. Moreover, irrevocable trusts provide protection against creditors in case of legal action against your heirs in the future, including a divorce.

Here’s an example of the benefit: If you give a $1 million property to your daughter through an irrevocable trust, you must count that $1 million gift toward your estate and gift tax exemption. But if that property becomes worth $3 million over the next 20 years, you’ve essentially removed $2 million in value out of your estate.

While trusts can help minimize estate taxes, there are potential drawbacks. For one, you generally cannot change the terms of an irrevocable trust once it is created. Moreover, gifting real estate in an irrevocable trust prevents your heirs from benefiting from “step-up basis” rules that allow them to avoid paying capital gains tax on the appreciation of the real estate before they received it. So, it’s important to weigh the benefits and drawbacks and consult your wealth and tax advisors before setting one up.

Fractional Interest Gifts.

Dividing ownership of property or land among two or more heirs can reduce the value of that gift for estate-tax purposes. The IRS allows the value of such gifts to be discounted because it assumes that it’s harder to sell something owned by more than one person and lack of marketability of the assets. However, the U.S. Treasury Department recently proposed regulations that, if implemented, could greatly limit the ability to apply fractional gift discounts. If finalized, the proposed regulations will have significant impact on the transfer tax consequences associated with transfers of interest in controlled family entities to family members. From a valuation perspective, taxpayers and appraisers currently incorporate applicable restrictions as defined by section 2704 through the application of discounts for lack of control and lack of marketability which in aggregate range from 15 to 40 percent. Refining the definition of applicable restrictions under section 2704, adding the new category of disregarded restrictions and ignoring insubstantial interests held by nonfamily members and charities would significantly limit the ability of the taxpayer and their estates to apply these discounts when estimating the fair market value of interest in certain family-owned entities that are transferred to family members.

Qualified Personal Residence Trust.

You can transfer a primary or secondary residence to a trust benefiting your heirs and retain the right to live in that home, rent free, over the length of the trust’s term. Meanwhile, the value of that gift is reduced for estate tax purposes based on the estimated “remainder interest” in the residence that your heirs will receive once the term is complete.

If you pass away before the term ends, your heirs receive no estate-tax benefits. Therefore, it’s important to set up the terms appropriately based on your personal situation. Once the term is complete, you may continue to lease the property from your heirs.

Life Insurance.

Beyond using trusts and other estate-planning techniques to transfer real estate, consider using life insurance to help your heirs cover any remaining estate tax liability. This provides a number of benefits. First, having life insurance proceeds prevents your heirs from having to quickly liquidate property — perhaps at an inopportune time — to pay their estate tax bill, which is typically due nine months after the decedent’s date of death. Moreover, life insurance proceeds do not count toward an estate’s value when they are given through an irrevocable life insurance trust.

When implementing any of these estate-planning techniques, it’s essential to work with a knowledgeable and experienced advisor who can help you determine which techniques make sense based on your personal situation and ensure you are using them correctly.

The strategies mentioned in this document will often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice. This information is provided to you as-is, does not constitute legal advice, and is governed by our Terms and Conditions of Use; we are not acting as your attorney. We make no claims, promises or guarantees about the accuracy, completeness, or adequacy of the information contained here. Clients’ tax and legal affairs are their own responsibility. Clients should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this document.

©First Republic Investment Management 2017